Hulu buyers, beware

Starz decision to end its relationship with Netflix is a sign of the difficulties content companies are having making money through Internet streaming. This should give potential buyers of Hulu pause. Distribution brands like Netflix and Hulu may not be the future.

Yesterday, it was announced that Starz, the source of an important portion of Netflix's streaming content, had decided not to renew its deal with Netflix. As a blog post at the LA Times reports, this was likely due to questions on Starz part as to whether the deal was in their long term self-interest. They "conclud(ed) that they would lose even more money by giving consumers a reason to subscribe to Netflix instead of the cable channel."

A lot has changed in the three years since Netflix first signed its deal with Starz, as streaming video has catapulted from an idiosyncrasy of the technically sophisticated to a habit practiced by 25 million Netflix subscribers. Many believe this has contributed to the erosion of cable subscriptions, a source of revenue that constitutes the majority of the money brought in by content "aggregators" such as Starz. This is the reason HBO, creator of critically acclaimed content such as "The Sopranos," "Boardwalk Empire" and "Game of Thrones," has avoided a deal with Netflix.

Netflix, of course, downplays the ramifications of the loss. In their official response (see that blog post), they note that Starz-sourced content accounts for only 8% of media streamed by viewers, and believe that figure will drop by 2% in the next six months. They attribute this relatively small share to a diversity of content sources. Netflix believes that content provider diversity mitigates the power any one source of content has over the Netflix streaming library.

To that, I must respond with a resounding: Maybe. Granted, acquiring content from multiple sources is essential, just as it is essential that a pizza restaurant not become beholden to one source of tasty Italian sausage. Starz, however, was a useful content source because it created variety, particularly in films, which consumers find quite appealing even if they don't watch Starz content exclusively. Licensing content from individual studios can also make your selection seem somewhat narrow. Lionsgate, for instance, tends to favor a very definite style and budget of movie, and Hulu's deal with Miramax creates a decent selection of Quentin Tarantino films (among others), but isn't going to offer the variety of a Starz deal.

The bigger issue for Netflix, however, is the risk that more sources of content will shy away from Internet streaming due to fears over the erosion of pay TV revenue. The Starz defection, in other words, could be the tip of the iceberg. It all depends on whether the new streaming model, one that faces potential bandwidth issues in the near future, makes enough money to offset the loss in pay TV subscriptions. Trends certainly don't look good. NBCUniversal, Fox Entertainment and Disney-ABC aren't selling Hulu because it is making them so much money they can't find enough buildings in Burbank in which to store the cash.

On that note, Starz decision should be a hint of potential business model issues for the big companies sniffing around Hulu. The idea that studios like NBC, Fox and Disney would band together to create a distribution channel for their own content makes decent sense, as streaming is certainly a great way to distribute content in today's world of Internet-savvy consumers. The notion of Hulu as a sellable commodity, however, seems weird to me. Yes, they have a bunch of client software that works with various types of devices (PCs, Set-Top Boxes), and they have server infrastructure to support streaming (though they may outsource some of it to others), but unless they are happy to confine themselves to content from the venture partners (which clearly isn't enough, otherwise they wouldn't be keen to sell), Hulu will have to spend a lot of money securing rights to content.

As a company like Hulu gets more successful, the cost of content will only go up. Content companies hold all the cards, as they have the stuff that people want to see. That gives them one hell of a trump card in discussions with distributors like Hulu (or Netflix), which makes ownership of a brand like Hulu or Netflix quite risky.

Frankly, I don't know what Hulu is actually selling except some client software and a supporting server infrastructure. That's not a lot of "stuff" to justify a rumored $2 billion valuation.

Personally, I'm not sure if a distribution "brand" like Netflix has long-term viability (however much I enjoyed the service). They've demonstrated that customers want streaming content, to be sure, but their future is bound to the whims of content companies. Content companies can be your best friend if you are funneling gobs of money their way (as cable companies historically have), or your worst nightmare if you are making less money for them than other revenue models.

That's why I think a more likely long-term model involves producers streaming content directly to customers. There would be some aggregation. Viacom has more than just South Park and Comedy Central in its arsenal, and the same applies to movie studios like MGM or Sony. However, a "direct to consumer" future would be a lot more "a la carte." Consumers could choose to, say, subscribe to the Viacom content source, as opposed to paying $100+ for 200 channels notable for how fast most viewers scan past them with their remotes. It would certainly result in a much wider range of content, and would level the playing field for content distribution to a level that has never been seen before.

Such a model would appeal immediately to this "cord cutter" (me) who hasn't had cable television since 2009. I am perfectly happy to pay $10 / month primarily to watch the Daily Show and the Colbert Report on Hulu (which, as a father of two young children, is about all I have time to watch). Yes, that's more than I would pay for that content as part of the 200 channel super-plan at Time Warner cable, but I save $90, which is a win for me.

Per unit costs, in other words, go up with "a la carte" video "channels" (which would really be silos of on-demand content). Instead of paying $100 / month for 200 channels most of which they never watch (an option which still may exist in some form), users of an "a la carte" plan would pay $50 - $60 for 10-15 sources of content. They save 40 bucks, and producers of those 10-15 channels get much more revenue per unit.

It's a "nice to have" if content companies could agree on common standards for content streaming and manipulation. This would lead to "aggregator" applications that make surfing across content sources easy (which constitutes much of the appeal of a Netflix or a Hulu). However, given that content companies will likely want more control over the customer relationship than they were willing to accept before (a result of the Internet), I think it could be more an iPhone "app" approach, where different sources of content create custom apps that stream their content in a custom fashion. If it works on mobile phones, it can work on the biggest display surface in the house.

The opportunity for a common payment gateway seems one area where third parties could get a cut of the revenue. Providers of streaming infrastructure will also make money, as lots of content companies are unlikely to want to manage their own streaming datacenter. Likewise, owners of popular distribution endpoints like the XBOX and Sony Playstation can also levy charges, much as Apple does with the iPhone. It's hard to get users to stick yet another "box" onto their TV. Companies like Microsoft and Sony have used the impulse to play computer games as a trojan horse through which to get high-powered computers attached to TV sets.

Most money would flow to content companies. However, the numbers who watch television are much larger than those who surf the Internet. Volume is the name of the game with television, and even small fees per subscriber can result in massive revenues.

Would that make more money than the current content relationship with cable television providers? If the market for cable TV is what it was ten years ago, that would be harder to do. Today, however, the current model is starting to fall apart. It's growing increasingly difficult to get large audiences for major budget TV shows, resulting in a rush to cheaper-to-produce reality TV shows. Plus, competition from Internet content - and not just of the video variety - is already cutting into TV watching time. Studies show that iPad owners end up watching LESS TV, opting instead to spend more of their time on Facebook or emailing friends than watching the "boob tube."

Starz decision to cut itself free of Netflix is a sign of the pressure companies like Starz are under to defend older business models. However, starving Netflix won't change the fact that consumers have ever more ways to entertain themselves at home in the evening. They'll have to find some way to reach customers over the Internet, even if the road doesn't pass by way of Netflix servers.